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Features: Storm Clouds And Silver Linings

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February 01, 2008

CANADA

When Canada’s dollar reached parity with the US dollar, it was cause for national celebration. For the country’s corporations, still reeling from the credit crunch, the muscular currency is a very mixed blessing.

In recent years the Canadian economy has been on a roll. Solid domestic policy and strong global growth helped the performance of both the economy and the financial markets. However, the second half of 2007 presented some serious challenges to corporate Canada.

First, the global credit market meltdown made raising capital difficult. Then transparency concerns hit the asset-backed commercial paper (ABCP) market, further crimping companies’ ability to raise funds. Finally, as interest rates continued to rise, so did the Canadian dollar.

The loonie hit parity with the US dollar for the first time in 31 years on September 20 and has been trading around that level ever since. The strength of the Canadian dollar is having a significant impact, says Alexandra Jemetz, director of Canadian research for Northern Trust Global Advisors. “Domestic currency strength acts as a pseudo-interest-rate increase. The resultant slowdown in demand for exports contributes to a decrease in GDP growth,” she explains.

With the United States taking about 75% of Canadian exports and with the Canadian dollar at its highest level in a generation, this could have a devastating effect on a number of industries—in particular, the natural resources, manufacturing and auto industries. “We expect that the strength of the dollar will bite more severely into economic growth this year,” says David Wolf, chief Canadian economist and strategist at Merrill Lynch.

However, for industries with net imports, the strength of the dollar has naturally been a big boost. “A strong dollar has benefited us,” explains Kent Brown, CFO of energy producer Canadian Hydro Developers. “The cost for equipment, which is typically from the US and Europe, has declined.”

“Quite simply the stronger currency hurts anyone that exports and helps anyone that imports,” says one analyst. “For Canadian companies with both international operations, how it will affect them depends on pricing power. Commodity producers where prices have gone up even more rapidly than currency has will be fine. Producers in manufacturing and resources where prices have not kept pace—for example, forestry—will struggle.”

For Canadian companies with international operations, the rise in Canadian dollar value means a re-evaluation of financial operations, adjustments in cash forecasting and potential changes in cash management operations. Brown notes that thanks to a low-risk FX management policy and the group’s hedging plan, this has not been an issue for Canadian Hydro: “We will be importing turbines from Europe. All currency exposure was hedged, so there is no effect on forecasting for 2008,” he says.

Wolf: "It will be a year of slower growth and some what lower inflation, but we don't see a substantial risk of recession."

Bank of Canada Easing
Merrill Lynch expects Canada’s central bank to cut rates by 125 basis points in 2008, down to 3%. Some others predict that the bank, under its new head Mark Carney, will keep monetary policy steady. “[Carney’s] comments indicate that he intends to continue on with the bank’s work at keeping inflation low, stable and predictable,” says one analyst. “Changes to the policy approach of the Bank of Canada are likelier to be at the edges rather than a wholesale change in how the bank operates.”

“We expect 1.7% economic growth for 2008—a bit below the consensus of 2.25%—with headline inflation forecast at 1.3%,” says Wolf. “It will be a year of somewhat slower growth and somewhat lower inflation, but we don’t see a substantial risk of recession—unlike with the US.”

The past half year was difficult for Canadian capital markets. The global market meltdown had a serious impact on market access and the cost of capital. In addition, a prime funding source for corporate Canada—the C$35 billion ($33 billion) non-bank ABCP market—virtually closed down after a number of investors raised concerns over collateral quality for the short-term products. It came to light that with a number of ABCP issues it was unclear who the end-issuer of the paper was, and thus fear arose over the true risk profile of such products. Shortly after the ABCP debacle, market participants agreed to restructure riskier ABCP paper into longer-term maturities, but it is still unclear how difficult that will be, given the complex derivatives and covenants included in the issues.

Jemetz says the ABCP market has stabilized somewhat, and people are finding opportunities. “The trick for investors is to look at opportunities that are transparent because the real issues in the ABCP space arose over lack of transparency,” she says. “This is an area that is being worked out, and we will see more transparency in this space in the future.”

Jemetz: Investors are still wary of putting their money into equities.

As a result of this and the credit market crunch, some corporates decided to wait for the market to improve before trying to access capital. For example, in the utilities sector a number of issuers mothballed credit-raising efforts, explains Nicole Martin, analyst at Standard & Poor’s in Toronto. “Given the generally adequate liquidity in the sector, several issuers have put off issuances, waiting for better market conditions,” she says. “Enbridge Gas Distribution was one of the few public issuers to face the market in a turbulent November, with a successful C$200 million issue.”

Brown at Canadian Hydro says the group has no plans to raise equity capital in 2008 but will put in place a number of construction credit facilities for several projects. “We also anticipate issuing a bond on a private placement basis for the long-term take-out financing of the $72 million debt bridge facility for the acquisition of Le Nordais,” he says. Canadian Hydro Developers acquired the 99 megawatt Le Nordais Wind Plant in Quebec for $120.75 million in December. Financing came through a portion of their $55 million equity offering—at $6.25 a share on a bought-deal basis—and a $72 million 12-month debt bridge facility.

The credit environment is clearly not what it was six months ago and may even worsen in the coming months. Financing issues will almost certainly be more difficult this year than in the past five years. However, 2008 should offer more opportunities to access the credit markets than in the second half of 2007. For corporates looking to raise funds in the bond market, the big concerns revolve around what will happen with government debt and credit and risk spreads around the world.

Equity Continues to Stumble
After a number of years of incredible strength for the Canadian equity markets, the second half of 2007 saw weak markets on the back of the US mortgage crisis and subsequent global market weakness. Investors are still cautious of investing in equities, Jemetz notes. “There are a lot of investors sitting on cash, waiting for opportunities. Everyone is really watching the US—particularly in regards to when the subprime mortgage fallout will stop impacting the markets,” she says.

Stock markets in Canada have yet to recover from this, and it will likely be some time before many companies can hope to access the equity markets with much success. According to Wolf, this is also in part because corporate earnings estimates are too high. “The current consensus sees 9% operating EPS growth in 2008, but we think they will be lucky to grow at all,” he says.

However, Jemetz feels that company fundamentals are still good. Balance sheets are strong, but sales growth may slow down, she says. “What you’ve seen lately is investor sentiment seeming to be low, but to many this is really a contrary indicator: When levels have reached their lows and the markets are actually starting to look good for the future, that is when there are the most opportunities,” she explains. “Everyone is bearish when the worst is over.”

CHANGING ACCOUNTING ENVIRONMENT
One big thing on the radar of all public companies is the move from Canadian GAAP (Generally Accepted Accounting Principles) reporting to IFRS (International Financial Reporting Standards). Canadian regulators have set a timeline to move to IFRS by 2011. This raises the issue of cost of conversion and the need for both internal and external resources to support the switch.

New high: Canada's economy boomed on the back of a strong loonie.

One accountant at a Big Four firm explains: “Companies must find the resources to manage this. With the need for internal infrastructure change, systems change and the learning curve for accounting and finance staff—it is really one of biggest issues we are facing right now.”

“This is certainly not something that companies can do alone,” this accountant adds. “Global accounting firms need to leverage their development of internal resources to help their clients and keep building capacity over time as the deadline approaches.”

There are changes that must occur across the whole of the accounting and financial reporting infrastructure in order to make the change a success. One big challenge may be on the academic side, according to the accountant. “We don’t have much material on this within the universities,” he says. “There are not a lot of professors who teach IFRS, and that has to change along with the regulatory changes and resource development at accounting firms.”

With a review now under way by the SEC to look at moving to IFRS in the United States, many similar issues have been raised for corporate America. Paul Bischler, vice president and controller of Burlington Northern Santa Fe Corporation, says one of the key advantages for US and Canadian companies moving to IFRS is that a single standard creates more efficient accounting processes for companies that currently report under both GAAP and IFRS. “There would be benefits to moving toward one set of accounting standards as there will be more comparability of financial reports across borders,” he points out.